978-0133423822 Chapter 14 Part 5

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9) Which of the following is a good reason to use divisional costs of capital?

A) Division managers have no vested interest in underestimating the capital costs

associated with their division.

B) Divisional costs of capital reduce are relatively easy to estimate.

C) Comparison irms are often engaged in various lines of business.

D) The divisions of a company represent well-deined lines of business with diferent risk

characteristics, for example oil and gas exploration and distribution through pipelines.

Question Status: New question

Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe

the divisional cost of capital as a viable alternative for irms with multiple divisions.

Keywords: project cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeof

10) Large irms are most likely to adjust for diferences in the risk levels of investments

taken on by diferent parts of the irm

A) by subjectively adjusting the company‘s WACC up or down.

B) by estimating individual costs of capital for each individual project.

C) by estimating individual costs of capital for each division or unit of the company.

D) by identifying the speciic sources of funding used by each division or unit.

Question Status: Previous edition

Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe

the divisional cost of capital as a viable alternative for irms with multiple divisions.

Keywords: project cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeof

11) The average cost of capital is the appropriate rate to use when evaluating new

investments, even though the new investments might be in a higher risk class.

Question Status: Previous edition

Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe

the divisional cost of capital as a viable alternative for irms with multiple divisions.

Keywords: project cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeof

12) The weighted average cost of capital is the minimum required return that must be

earned on additional investment if irm value is to remain unchanged.

Question Status: Previous edition

Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe

the divisional cost of capital as a viable alternative for irms with multiple divisions.

Keywords: project cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeof

13) Using separate cost of capital estimates for individual projects is not appropriate when

the projects are relatively few in number and large in scale.

Question Status: New question

Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe

the divisional cost of capital as a viable alternative for irms with multiple divisions.

Keywords: project cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeof

14) Using a irm’s overall cost of capital to evaluate individual projects creates an incentive

for managers to avoid high risk projects with potentially high returns.

Question Status: New question

Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe

the divisional cost of capital as a viable alternative for irms with multiple divisions.

Keywords: project cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeof

15) Most large irms use individual costs of capital to evaluate all projects.

Question Status: Previous edition

Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe

the divisional cost of capital as a viable alternative for irms with multiple divisions.

Keywords: project cost of capital

Principles: Principle 5: Individuals respond to incentives.

16) Tantasqua Paper Products is composed of 3 divisions: industrial paper products,

commercial paper products, and a forestry division which grows trees for wood pulp used

in the paper-making process. Each of these divisions takes on a large number of projects

with difering risk characteristics. Tantasqua now uses a single discount rate based on the

company’s WACC to evaluate all capital budgeting proposals. Discuss the advantages and

disadvantages of this approach.

Question Status: Previous edition

Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe

the divisional cost of capital as a viable alternative for irms with multiple divisions.

Keywords: project cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeof

17) Tantasqua Paper Products is composed of 3 divisions: industrial paper products,

commercial paper products, and a forestry division which grows trees for wood pulp used

in the paper-making process. Each of these divisions takes on a large number of projects

with difering risk characteristics. Tantasqua now uses a single discount rate based on the

company’s WACC to evaluate all capital budgeting proposals. Discuss the advantages and

disadvantages of switching to an approach based on separate discount rates for each

division or even the risk level of each project.

Question Status: Previous edition

Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe

the divisional cost of capital as a viable alternative for irms with multiple divisions.

Keywords: project cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeof

14.6 Flotation Costs and Project NPV

1) Jen and Barry’s Ice Cream needs $20 million in new capital to expand its production

facilities. It will use 40% debt and 60% equity. The company’s after-tax cost of debt is 5%

and the cost of equity is 12.5%. Flotation costs will be 3% for debt and 9% for equity.

Compute Jen and Barry’s weighted average lotation cost.

A) 6.6%

B) 6.0%

C) 9.5%

D) 16.1%

Question Status: Previous edition

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

2) Jen and Barry’s Ice Cream needs $20 million in new capital to expand its production

facilities. It will use 40% debt and 60% equity. The company’s after-tax cost of debt is 5%

and the cost of equity is 12.5%. Flotation costs will be 3% for debt and 9% for equity. What

rate should be used to discount the cash lows from the expansion project?

A) 6.6%

B) 6.0%

C) 9.5%

D) 16.1%

Question Status: Previous edition

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

3) Jen and Barry’s Ice Cream needs $20 million in new capital to expand its production

facilities. It will use 40% debt and 60% equity. The company’s after-tax cost of debt is 5%

and the cost of equity is 12.5%. Flotation costs will be 3% for debt and 9% for equity. What

is the total amount of capital that will need to be raised to inance the expansion project?

A) $22,386,000

B) $20,000,000

C) $21,200.000

D) $21,413,276

Question Status: Previous edition

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

4) Stonehedge Dairy will expand its organic yogurt production capacity at a cost of

$10,000,000. The expansion will increase after-tax operating cash by $1.4 million dollars

per year for the next 20 years. Stonehedge’s WACC is 10%. To raise the $10,000,000

Stonehedge will need to issue new securities at a weighted average lotation cost of 10%.

What is the NPV of the expansion?

A) $918,989

B) $807,878

C) $11,918,989

D) $1,918,989

Question Status: Previous edition

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

5) When new capital must be raised for an expansion project, lotation costs should

A) be deducted from the operating cash lows.

B) increase the initial investment outlay.

C) be considered in recomputing the irm’s overall WACC.

D) be ignored.

Question Status: Previous edition

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

6) Larger issues of new common stock can cause ________ to increase.

A) lotation costs

B) the investor’s required rate of return

C) the stock price

D) the tax rate

Question Status: Previous edition

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

7) As the size of a inancing issue increases, the ________ usually decreases on a percentage

basis.

A) cost of equity

B) lotation cost of the issue

C) efective tax rate

D) both A and B

Question Status: Previous edition

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

8) The cost of newly issued common stock is greater than the current cost common equity

because of

A) capital gains taxes on retained earnings.

B) lotation costs on newly issued common stock.

C) capital gains taxes on newly issued common stock.

D) all of the above

Question Status: Previous edition

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

9) Flotation costs

A) have no efect on the project’s NPV.

B) increase the irm’s cost of capital, but only for the life of the project.

C) increase the initial investment in a project.

D) permanently increase the irm’s cost of capital.

Question Status: New question

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

10) Flotation costs increase the amount of funds that must be raised to inance an

investment.

Question Status: Previous edition

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

11) Flotation costs are usually ignored when computing the NPV of projects inanced with

newly issued securities.

Question Status: Previous edition

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

12) All capital projects incur lotation costs, no matter how they are inanced.

Question Status: Previous edition

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

13) Flotation costs are higher for debt than for equity because debt creates more risk to

the issuer.

Question Status: New question

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

14) A project with a positive NPV may have a negative NPV when lotation costs are

considered.

Question Status: New question

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value

15) Sprite Communications will erect 20 new transmission towers at a total cost of

$15,000,000. The expansion will increase after-tax operating cash lows by $2.3 million

dollars per year for the next 20 years. Sprite’s WACC is 12%. To raise the $15,000,000,

Sprite will need to issue new securities at a weighted average lotation cost of 12%. What is

the NPV of the expansion?

Question Status: Previous edition

Objective: 14.6 Adjust NPV for the costs of issuing new securities when analyzing new investment

opportunities.

Keywords: lotation costs

Principles: Principle 3: Cash Flows Are the Source of Value